Functioning true to form

Convertible bond funds continue to beat market at large

JustinWiser

WASHINGTON (CBS.MW) - Convertible bonds are designed to offer the upside potential of stocks while limiting the downside risk. Over the past year, these hybrid securities lived up to their billing.

"Convertibles have had some incredible upswings and downswings in the past two or three years, but they've still done as advertised ."
Chris Wiles, Rockhaven Premier Dividend Fund

Last year, as the Nasdaq plunged 39.3 percent and the S&P 500 dropped 9.1, the average convertible bond fund eked out a 0.2 percent return, according to Lipper Inc. Through Monday, the average convertible bond fund is down 7.1 percent year-to-date, while the S&P 500 has dropped 12.7 percent and the Nasdaq has fallen 22.3 percent, Lipper said.

"Convertibles have had some incredible upswings and downswings in the past two or three years, but they've still done as advertised," said Chris Wiles, manager of the Rockhaven Premier Dividend fund
RAMCX, -0.10%
"We were up more than 50 percent in 1999, and then last year we were still positive."

Double-edged sword

Convertible bonds offer income like a standard bond, along with the option to convert the bond to shares of the issuing company's common stock. Buyers pay a premium for the extra income and the conversion option.

When stock prices are rising, convertibles can ring up huge returns. In 1999, convertible bond funds gained about 30 percent, according to Morningstar. They added another 10 percent in the first quarter of 2000.

Plummeting stock prices have caused many "busted" convertibles.

The heady performance was due in large part to the rally in technology and telecommunications issues, which recently comprised half of the convertible universe.

When stock prices are falling, convertibles shield investors from losses with a steady income stream. A convertible bond issued by Vitesse Semiconductor
VTSS
for example, last week had gained about 2 percent year-to-date, while the stock is down more than 30 percent, Morningstar said.

Plummeting stock prices have caused many "busted" convertibles. In this case, a stock's price has fallen so far that converting a bond has become a worthless option. Busted converts might pay yields as high as 12 or 14 percent, vs. average convertible yields in the 4 to 5 percent range.

Economic gravity

But along with higher yields comes higher risk, particularly when the economy cools, Lipper research analyst Mary Cho said.

"As the economy weakens, the default risk rises," Cho said. "That would hurt the risky portion of any fixed income class, whether they are hybrids or not."

Wiles, whose Rockhaven fund has a three-year annualized return of 14.1 percent, said quality always has been his top concern in choosing convertibles.

"Over time, quality usually outperforms junk," Wiles said. "We look first at a company's common stock. If we're not going to buy the stock, we're not going to buy the convertible."

Wiles said he also keeps his portfolio pegged to an index model of sector weights, to avoid loading up in one area. He now is 24 percent in tech, and 10 to 12 percent each in health, energy and telecom.

Many blame the recent slip in high-yield bond performance on economic concerns and a subsequent flight to quality. The same trend may affect convertible bonds going forward, Cho said.

"Some fixed income categories are highly impacted with what's going on in the equity markets. High yield bonds and convertibles are vulnerable to this," Cho said.

Convertible bond funds range in nature from conservative to aggressive. Some favor value-oriented stocks and convertibles while others pay large premiums for volatile, equity-sensitive converts.

The following convertible funds are Morningstar analyst picks that span the risk spectrum: Fidelity Convertible Securities
FCVSX, +0.10%
with a 15.9 percent annualized, five-year return, Calamos Convertible
CCVIX, +0.00%
up 15.2 percent a year over that span, and Davis Convertible Securities
RPFCX, +0.44%
which returned 10.8 percent annually over that period.

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